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Monday, May 23, 2011

Financial Management problem and solutions part one

1-3: What is a firm’s fundamental and intrinsic value? What might cause firms intrinsic value to be different than its actual market value?

Firm’s fundamental and intrinsic value could be defined as firm’s real or actual value (worth) based on an underlying perception of its true value including all aspect of business (invstopedia, 2010). Fundamental analysis helps to determine firm’s fundamental value. To identify firms fundamental value, fundamental analysis analyze the firm’s financial information such as income statement, balance sheet, and cash flow statement and other factors such as firm’s competitive advantage, earning growth, sales revenue growth, market share, financial reserve, and quality of management.

1-4: Edmund Enterprises recently made a large investment to upgrade its technology. Although these improvements won’t have much of an impact on performance in the short run, they are expected to reduce the future cost significantly. What impact will this investment have on Edmund Enterprise’s earnings per share this year? What impact might this have on company’s intrinsic value and stock price?

Since firm has recently invested large capital to upgrade their technology, earning per share of the firm will go down. The reason why firms earning per share go down is that the firm has less money (as expenses goes up, profit decreases due to capital investment) to distribute dividends to the shareholders.

The intrinsic value of firm may increase due to positive future perception of investor towards firm that firms future cash flow will increase due to the change in technology. Since investors have positive perception towards firm , the demand of stock goes up as a result intrinsic value and stock price go up.

1-6: What are financial intermediaries and what economic function do they perform?

Financial intermediaries are financial institutions such as bank, insurance company, credit union, stock exchange, and so on who works as a middleman in between those who want to borrow money and those who want to lend money. The reason for the existence of financial intermediaries is they process fanatical information more effectively and efficiently than lenders and borrowers can do individually.According to Rober W. Kolb and Ricardo J. Rodriguez (1996), “A financial intermediariay is a financial institution that acquires funds from one group of investors and make available to another economic unit. Thus financial intermediaries play a very pertinent role in the economy by channeling funds from surplus saving units to deficit saving units.”

The economic roles of financial intermediares are:

·Direct financing: Financial intermediaries link the surplus spending units to deficit spending units. They make a direct flow of funds from lenders to borrower by issuing financial claim.

·Indirect financing: financial intermediaries perform indirect financing by purchasing direct securities with one set of characteristic from borrows or deficit spending units and transform those securities into indirect securities with different set of characteristic and sell it to the surplus spending units (Shrestha & Bhandari, 2005).

Beside this some other key financial role played by financial intermediaries are:

a)They perform denomination divisibility functions.

b)Perform Maturity flexibility function.

c)Risk diversification function.

d)Liquidity functions.

1-7: Is an initial public offering an example of primary or secondary market transaction?

The initial public offering is an example of primary market transaction because those securities are first hand securities. The primary market is that type of market where only the first hand securities are traded, therefore initial public offering is an example of primary market transaction.

2-3: If a typical firm reports a$20 million of retained earnings on its balance sheet, can a firm definitely pay a $20 million cash dividend?

Retained earnings are residual portion of firm’s net profit after paying dividend. In the above case $20 million cannot be paid as cash dividend because firm reinvest retained earning into core business function or firm may use that amount to pay debt. Another reason is that firm may have used that amount on short term or long term investment.

2-4: Explain the following statement: “whereas the balance sheet can be thought of as a snapshot of the firm’s financial position at a point of time, the income statement reports on operations over a period of time”

Balance sheet represents firm’s financial summary at a specific point of time. The left side of balance sheet shows all assets of firms and right side of balance sheet shows all capital and liabilities of firm for the particular point of time. For example, December 31 or June 30.

Income statement represents company’s financial performance over a period of time such as a fiscal year. Left side of income statement includes all the expenses made by company during the fiscal year where as right side of income statement includes all the income gained by company during the fiscal year. The overall purpose of income statement is to show firms performance over a period of time.

2-5: What is operating capital and why it is important?

Operating capital is the amount of money that the firm invested in order to operate day to day business. The source of operating capital is short term loan and short term securities where as uses of operating capital are investment on labor and raw materials. Operating capital is also known as working capital which is calculated as:

Working capital = Current Assets – Current Liabilities.

Operating capital is important because it helps business to survive in short run and also helps to meet the short term investment opportunities. In addition to this proper management of operating capital helps firm to develop good credit history by timely payment of creditors and get cash discount as well.

2-6: Explain the difference between NOPAT and net income. Which is a better measure of the performance of the company’s operations?

NOPAT (Net Operating Profit After Tax) is Operating profit minus tax. The concept of Net operating profit after tax does not take account the idea that business must cover both capital cost and operating cost. The formula: Operating profit (1-Tax)

Net income is income before tax minus tax. The concept of Net income accounts the idea that business has to cover both operating as well as capital cost, i.e. interest. The formula: EBT (1-Tax).

Net operating Profit after tax is the better measure of company’s operating performance because it solely represents expenses and income from operating activities.

2-7:What is free cash flow? Why is it the most important measure of cash flow?

Free cash flow is total amount of money that the company has left over after paying all the expenses necessary to operate business as well as all the investment made. Free cash flow can also be defined as a net operating profit after tax minus the increase in net operating assets.

2-8: If you were starting a business, what tax considerations might cause you to prefer set it up as a proprietorship or a partnership rather than a corporation?

Profit of corporation is subject to double tax because Corporation itself is a single entity and has to pay tax on its income and when shareholders take part of its income they have to pay tax on dividends as well. In a proprietorship or a partnership they only have to pay income tax on the profit made by business.